Entrepreneurs Facing Lease vs. Own Decision

August 17th, 2010

Entrepreneurs -- be they owners of accounting firms, law firms, machine shops, local restaurants, clothing stores, or other small businesses -- face the question of whether to lease or own the property housing their business.

According to real estate experts, there is no "right" or "wrong" answer. A variety of factors pertinent to the individual business and the owner's objectives, as well as local market factors, must be taken into account before an informed decision can be made.

Whether or not the company will grow -- and grow substantially in the future -- is one of the principal factors influencing the lease versus own decision. If the business is expected to grow dramatically over the next three to five years, owning is probably not a good option. An entrepreneur is better off leasing in that situation.

By leasing, the entrepreneur avoids the prospect of either purchasing a building that's too large, with the expectation of growing into it (which may or may not work out over time), or one that only accommodates current space needs, which will be too small in a few years.

The next issue to consider is the availability of flexible lease terms. Landlords in many markets today offer a long-term lease of seven to 10 years with a clause allowing the business to exit the lease after five years with sufficient notice (six months or more). In this case the tenant would pay the unamortized costs of tenant improvements and leasing commissions in exchange for the flexibility of getting out.

This and other kinds of flexibility provided in a lease often make leasing a more prudent option than owning real estate. Small business owners initially should try to avoid tying up valuable capital in real estate assets. Leases tend to lower fixed costs because there is no required down payment or amortization of loan principal. Lowering fixed costs reduces overall business risks.

Leasing real estate offers a business the option to still occupy and control a property, but utilize capital in other ways. From the perspective of purchasing a business property, an entrepreneur in business a few years with few plans to grow the business significantly might consider an outright purchase. If a business owner knows he or she can manage the company effectively in the same building for 10 years or longer without requiring additional space for inventory or personnel, then he or she should take a hard look at the cost differences between leasing and owning.

But even with ownership there are pitfalls. Mortgage payments are but one component of the cost of ownership. An owner must ensure that he or she has the time, talent or resources to handle the day-to-day operation of a property and a building. Furthermore, if you purchase the property and 10 years in the future the business gets into financial difficulties, you as the owner do not have the flexibility a lease would offer. An owner simply does not have as much flexibility as a tenant.

Another problem with ownership is it carries a potential opportunity cost. Owning real estate through either equity or mortgage loan financing ties up capital or credit that might otherwise be invested in the business for new equipment or additional personnel. Such operations investment might produce greater returns than the real estate investment, creating an opportunity cost that accompanies real estate ownership. By owning, an entrepreneur should consider the costs of "lost opportunities".

If the entrepreneur opts for a lease over ownership, certain criteria must be followed in order to secure the best possible lease. For example, leases should provide the tenant with an acceptable level of control over the asset (i.e. the building and their space). These control issues include assignability, reasonable condemnation and taking provisions, expansion rights, and renewal and purchase options. Lease escalation clauses should be manageable and clearly defined in order to lessen downside risk. If the entrepreneur opts to purchase, when to make that purchase is paramount to getting the best price. Analyzing current market conditions and available sales information provides the buyer with valuable insight.

Lease vs. own analysis is definitely a situation-by-situation equation. There are many factors to consider and the decision should be made in conjunction with a qualified real estate professional who has proven experience in that particular market.